Regulators & Courts: Carbon trading could become a $2 trillion new market if the US enacts a national cap-and-trade system. The CFTC says it is ready to regulate environmental futures and options, as exchanges gear up with new contracts.

Last Friday the United States Environmental Protection Agency made news by publicizing its finding that six greenhouse gases, including carbon dioxide, may endanger public health and welfare.

This supports an attempt by Congressional Democrats to pass a cap-and-trade bill that is expected to reduce emissions of carbon dioxide and other heat-trapping gases by lowering the caps on industrial emissions and allowing companies to trade pollution permits.

If the legislation goes through, it will bring about a national cap-and-trade system in the US. But some states have already implemented their own system. The Regional Greenhouse Gas Initiative by ten states will on June 17th hold its fourth auction of carbon credits for more than 200 power plants. RGGI's first auction was in September 2008.

Futures and options on RGGI credits are trading on the Chicago Climate Futures Exchange, which last week announced a new daily trading record for RGGI and other environment-related derivatives. The 18,381 futures and options contracts traded represented a 66% increase from the previous record, set the previous week.

CCFE is designated by the Commodity Futures Trading Commission to offer standardized and cleared futures and options contracts on emission allowances and is supervised by the National Futures Association. Its parent company also runs the European Climate Exchange, a participant in the European Union Emissions Trading Scheme.

In other words, environmental futures and options have made some headway but will really get going if the Democratic majority passes cap-and-trade legislation. As it stands now, the House bill aims to reduce American greenhouse gas emissions 20% by 2020 and 83% by 2050. That would require a lot of capping and trading.

Preparations

In the meantime, futures regulators are looking to oversee what could become the largest commodity arket. The Commodity Futures Trading Commission, which expects to monitor and regulate the trading of derivatives associated with carbon dioxide allowances, extended its energy committee to include environmental markets.

CFTC Commissioner Bart Chilton says the mission, mandate and membership of the committee is being expanded “to ensure that we are ready for what could be a $2 trillion market in the future.”

The commission has experience in this area—it regulated environmental markets such as the sulfur dioxide derivatives market that came into existence after Congress tackled acid rain. “We have a proven track record as a sure-footed regulator of environmental markets since 1995,” Mr. Chilton said in a statement.

The US is following the European Union, which launched a cap-and-trade system in 2005. Bu the EC's experience has demonstrated how difficult it can be to make such markets work. “I'm hopeful we in the US can learn from the European experience to ensure that these markets take off in an orderly, efficient and effective fashion,” Mr. Chilton said.

Legislation vs. Regulation

It is not clear whether the cap-and-trade bill will become law. Republicans remain opposed and not all Democrats are expected to support it. Congress is to begin hearings this week.

EPA Administrator Lisa Jackson seconded President Barack Obama's call for a low-carbon economy and strong leadership in Congress on clean energy and climate legislation. In addition to the effects of greenhouse gases on health, her agency emphasized that climate change poses a national security risk for the US—by increasing resource scarcity, global warming can incite violence in destabilized regions.

The EPA did not propose regulations against climate change and its finding has to be subjected to public comments. Both the President and Ms. Jackson favor comprehensive legislation to address the global warming issue rather than a regulatory approach.

But if legislation is not forthcoming, regulation is almost certain, whether through a market instrument like cap-and-trade, new direct controls or a combination of methods. The US Supreme Court ruled a couple of years ago that if human health is threatened, the EPA has the authority to regulate emissions that cause global warming, and ordered the agency to study the effects of heart-trapping gases.

Environmental initiatives are a priority for the White House. In addition to environmental goals, the administration looks to create jobs in alternative energy. President Obama has presented combating climate change as a way to boost the ailing economy. He will probably play a big role at the international meeting that will convene in Copenhagen this December to negotiate a follow-up carbon-capping agreement to the Kyoto Protocol.

Global Market

With the US leading the way, other countries are likely to follow. There are already indications that this will happen. A Canadian government panel that gives advice on environmental issues said that Canada will have to put a price on carbon and set up a national cap-and-trade system, given that President Obama wants to have a US cap-and-trade system in place by 2012.

The Canadian panel said the price of carbon should be around $83 a metric ton by 2020 and double from that level by 2050, according to a report from Reuters. Canada is the largest supplier of energy to the US.

Australia is another country that is planning to go this route. The Australian government proposed a cap-and-trade system to start operating in mid-2010.

Climate exchanges have geared up by introducing new products. In November CCFE listed futures contracts based on emission allowances under the anticipated US greenhouse gas program. Contracts that expire in December 2013, 2014 and 2015 were traded, with prices ranging from $11.75 to $15.00 per metric ton of carbon dioxide.

CCFE's Carbon Financial Instrument-US Allowance Futures call for the delivery of greenhouse gas emission allowances that would be usable for compliance under a mandatory federal cap-and-trade program. If such a program is not enacted by the time the contracts expire, the delivery of other specified mandatory CO2 allowances would be required.

Richard Sandor, chief executive of Chicago Climate Exchange, said that the customers requested a tool for hedging US carbon policy and allowance prices.

Who traded the first US Allowance Futures on November 18th? Both industrial and financial players were in the market, according to the exchange. On the financial side, participants included C-Quest Capital LLC, Digilog Global Environmental Master Fund, Environmental Capital Management, Green Fund LLC, Infinium Capital Management LLC and the Royal Bank of Canada.

They traded forty-two contracts, representing 42,000 metric tons of carbon dioxide allowances. It was a modest start, but the way the political winds are blowing, it looks like environmental markets will get an immense stimulus from Uncle Sam.